ISSUE 12 WINTER/SPRING 2017 £25 30 $35 EQUITY · Source: EY: 2016 Global Private Equity Fund and...

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PRIVATE EQUITYFINDINGSInsights from the world’s private equity research

ISSUE 12 WINTER/SPRING 2017 £25 €30 $35

THE FEE FACTORWhy some terms are not as LP-friendly as you think

IMPACT FUNDSWhich LPs invest in them – and should they?

RIPPLES OF CHANGEHow PE investments disrupt entire business sectors

KEEPING IT TO THEMSELVESWho profits from insider rounds in VC?

INCLUDING CONTRIBUTIONS FROM: CALIFORNIA INSTITUTE OF TECHNOLOGYCOLUMBIA UNIVERSITY | ERASMUS UNIVERSITYHARVARD UNIVERSITY | MIT SLOAN SCHOOL OF MANAGEMENT SAÏD BUSINESS SCHOOL | STANFORD UNIVERSITY

PLANTING THE RIGHT SEEDSWhy some LPs outperform their peers

CONTENTS

4 By the numbers

LPs split on impact investing; Higher fees and carried interest not linked to top performers; Expense allocations remain contentious for LPs; First-timers outperform established funds; LBO and VC performance – US president matters.

6 PE’s transformative effect on industry sectors

Much has been written about the way private equity affects individual companies, but does its involvement influence what happens across sectors? And if so, how? Two recent academic papers study the issue.

10 Be careful what you wish for

The trend for more LP-friendly fee and carried interest terms may result in some unintended consequences, new research finds. We find out why.

“I’ve often wondered why portfolio company fee negotiations centre on the fraction of offset rather than the amount being charged. Until the SEC got involved, no one really talked about how these fees presented a conflict of interest.”

Ludovic Phalippou, Saïd Business School

16 How do some LPs outperform their peers?

There is a wide variation in LP performance in private equity, but how much of this is due to LP type, governance or skill? We speak to the authors of three academic papers on the subject and gather the views of two experienced LPs.

“The market today is just far more competitive for PE, so investors who are latecomers to the market won’t have some of the advantages of LPs that were 15 or 20 years ahead of them into the asset class.”

Maria Kozloski, Global head and CIO, IFC

22 Assessing the impact

As impact investing increases in popularity, we examine a paper that looks at where demand is strongest and ask a seasoned LP for her opinion on this trend.

25 Life on the inside

How do venture capital inside rounds perform compared to those made alongside new investors? And why do VCs do them? We talk to the author of new academic research on the subject.

“The paper’s findings are different than you might expect – we’re not seeing evidence of situations where the entrepreneur is being taken advantage of.”

Michael Ewens, California Institute of Technology

FOREWORD

Professor Josh LernerHead of Entrepreneurship Department, Harvard Business School

Jeremy Coller Chief Investment Officer, Coller CapitalP

rivate Equity Findings provides a forum for debating the world’s best academic research into private equity, for challenging conventional wisdom

on the asset class, and for sharing insights from the general partners and limited partners who constitute the cutting edge of the industry.

For many years, the Coller Institute of Private Equity at London Business School played a critical role in the success of Private Equity Findings, and we would like to record our thanks for the outstanding work of Professor Eli Talmor and Professor Francesca Cornelli in developing Private Equity Findings into the unique publication it is today.

This issue sees the formation of a new partnership between the Coller Research Institute at Coller Capital and Professor Josh Lerner of Harvard Business School.

This edition of Private Equity Findings lifts the veil on several less obvious aspects of private equity policy and practice.

In PE’s transformative effect on industry sectors, we discover that private equity’s disruptive effects extend far beyond individual portfolio companies, prompting significant change within the industry sectors in which those companies are operating.

We note the wide variations in the performance of investors’ private equity portfolios, and ask How do some LPs outperform their peers? Using the findings of three recent research papers, and perspectives from two experienced private equity investors, we examine whether these performance variations are a consequence of LP skill, or of governance differences, or even of investor type.

The article Be careful what you wish for casts a critical eye over the fees and incentives received by private equity managers, along with the timing of their payouts, with results that many investors may find surprising.

In our Head-to-Head feature, Assessing the impact, we analyse LPs’ growing interest in social impact investing, and provide a challenge to the trend from an experienced private equity investor.

Our final article, Life on the inside, focuses on VC ‘insider rounds’ (funding rounds composed entirely of the company’s existing investors). It highlights recent research by academics at Caltech, Harvard and Stanford, which finds that insider rounds are associated with significant underperformance in the portfolio companies where they occur.

This edition of Private Equity Findings has already stimulated lively debate among its numerous contributors. We hope you find it equally stimulating and, as always, we welcome your thoughts and feedback. You can contact us by email at [email protected].

2 PRIVATE EQUITY FINDINGS WINTER/SPRING 2017 COLLER RESEARCH INSTITUTE 3

BY THE NUMBERSLPs split on social impact investing

Social impact investing is becoming an increasing focus for LPs: half of the institutions surveyed for the Winter 2016/17 Global Private Equity Barometer either have social impact investments in their portfolios or plan to add them within two years.

This split tallies with some of the findings reported in our feature on pages 22-24, which explores the demand for impact investing among institutions.

However, despite institutions’ growing engagement with social impact investing, individuals working for these institutions overwhelmingly believe that social impact investing is only an appropriate use of their organisations’ funds if it does not reduce potential financial returns. It is not clear that this personal caveat is acknowledged in LP institutions’ current embrace of impact investing.

LBO and VC performance – US president matters

As the US settles into a new presidential administration, research from State Street and the Private Capital Research Institute analyses private equity returns according to the political affiliation of the President at the time. It finds that, relative to public markets, private equity outperformed most during the Bill Clinton years (1.36 public market equivalent (PME)) and least during the Ronald Reagan and Barack Obama periods (1.03 PME).

Overall, the analysis suggests that private equity vintages started under Democratic administrations fare marginally better than

those raised in Republican periods (1.21 PME versus 1.17 PME).

The analysis excludes funds raised in the last two years of an administration before a change in political control, to account for the fact that these would be invested and harvested under the new administration. It also excludes the immature 2014 and 2015 vintages.

Higher fees and carried interest rates not linked to top performers

Higher rates of management fees and carried interest are not linked to better performance, new analysis shows. Indeed, top-quartile funds in all but the $1bn-plus fund size tend to charge among the lowest management fees, according to Preqin’s Private Capital Fund Terms report, while bottom- and third-quartile funds appear to levy among the highest management fees for many fund sizes.

While this may lead some to assume that top-quartile players make up their lower management fees through higher carried interest rates, further Preqin analysis suggests this isn’t always the case. Over half of those charging a carried interest that is lower than the industry standard of 20% are top-quartile funds, while only 23% of those funds charging more than 20% are in the top quartile. This suggests that carried interest rates are not a reliable indicator regarding the future performance of a fund.

The way private equity firms account for, and report, their expenses has been the subject of intense scrutiny since the financial crisis, yet many LPs remain dissatisfied with the level of transparency among funds across a wide range of items, according to an EY survey.

Over two-fifths of investors say they are unhappy with expense allocation reporting in relation to consultant, broken deal and annual meeting fees, the 2016 Global Private Equity Fund and Investor Survey finds.

As we report on pages 6-9, LPs now have a greater focus on how fees (in this case portfolio company fees) are being levied and reported.

With nearly half (47%) of LPs telling Preqin that it has become harder to find attractive private equity fund opportunities over the last 12 months, there is evidence to suggest that they are increasingly turning to first-time funds. Over half of investors (51%) will now invest, or consider investing, in first-time funds, up from 39% in 2013, finds a Preqin report, Making the Case for First-Time Funds.

Those willing to back new players have generated strong returns. Indeed, the Preqin figures suggest that the median net IRR for first time funds has outperformed established funds in the post-crisis period by some margin.

The chart includes all private capital strategies (i.e., including real estate, infrastructure and private debt, as well as buyouts, venture capital, and growth). According to Preqin data, though, nine of the top 10 best-performing first-time funds across all vintages are venture capital and buyout funds. More recent vintages (2006-2013) show a slightly different pattern, with five of the top 10 performers in buyout and venture capital, while infrastructure, real estate and distressed debt funds make up the remainder.

Source: Global PE Barometer – Coller Capital – Winter 2016/17 edition

Source: EY: 2016 Global Private Equity Fund and Investor Survey

Source: Leslie Jeng and Josh Lerner, “Donkeys vs. Elephants: The Private Capital Edition,” State Street Private Equity Insights, 4th edition, Q2 2016.

% of investors dissatisfied with the level of transparency related to expense allocations

Average private capital PME

LP organisations’ policy on social investing over the next 24 months

Private capital – median net IRRs by vintage year: first-time funds vs. non-first-time funds

LPs’ personal views on the appropriateness of social impact investing as a use of their organisations’ funds

Source: Preqin

Consultant 45%

Broken deal 44%

Annual meeting 42%

Compliance 34%

Investor portal 32%

D&O insurance 29%

SOC 1 20%

R Reagan (’83 onwards) 1.03

GHW Bush (excl. ’91 & ’92) 1.24

W Clinton (excl. ’99 & ’00) 1.36

GW Bush (excl. ’07 & ’08) 1.29

B Obama (through ’13) 1.03

All Democrats 1.21

All Republicans 1.17

Expense allocations remain contentious for LPs

First-timers outperform established funds

Average management fee of private capital funds by fund size and quartile ranking, all vintages

Source: Preqin

Aver

age

man

agem

ent f

ee

durin

g in

vest

men

t per

iod

(%)

Less than $50m

$50 to$99m

$100 to$249m

$250 to$499m

$500 to$999m

More than $1bn

0.5

1.0

1.5

2.0

2.5

TopQuartile

2ndQuartile

3rdQuartile

BottomQuartile

Fund size

Vintage year

Med

ian

net I

RR

(%

)

5

10

15

20

25

12111009080706050403020100

First-time funds

Non first-time funds

Yes, even if it failsto optimise our

financial returns

Only if it doesnot reduce ourfinancial returns

20% 80%

No plans to invest47%

Decrease/stop 3%

Maintain 26%

Increase 14%

10%Begin

Yes, even if it failsto optimise our

financial returns

Only if it doesnot reduce ourfinancial returns

20% 80%

No plans to invest47%

Decrease/stop 3%

Maintain 26%

Increase 14%

10%Begin

TRENDS AND STATISTICS


PE’s TRANSFORMATIVEEFFECT ON INDUSTRY SECTORS

FEATURE

Private equity’s impact on portfolio companies has long been the subject of debate, but scrutiny of its broader effect on the industries in which it

invests has been less comprehensive, with many studies concentrating on comparing the performance and characteristics of PE-backed companies against those without PE investment. Two recent research papers take a look at PE’s broader effect on the industries in which it invests, with some surprising results.

Settling differences of opinion“After the financial crisis and through the 2012 US presidential election, private equity received a huge amount of attention,” explains Shai Bernstein, co-author of Private Equity and Industry Performance. “On one side, people were saying that this industry was not regulated and having an adverse effect because of excessive leverage and cost-cutting. On the other, people argued that private equity’s concentrated governance model, discipline and provision of capital meant it made industries more robust. The differences in perception were so sharp, it was an interesting area to research.”

Industry performance In the Bernstein et al paper, the authors seek to establish whether PE investment within an industry had an impact on the sector’s growth and cyclicality. The academics examine the growth of industries with recent PE investment in comparison with those that have not received PE financing. They find that PE-backed industries not only grew faster, but that there is no evidence to suggest PE involvement in a sector makes it any more volatile or vulnerable to financial shock. “Before starting the research, I felt the results could have gone either way,” says Bernstein. “What really surprised me was just how strongly the findings on growth and low cyclicality came through.”

The authors perform a number of additional analyses to determine whether PE investments are causing these industry changes or whether the results are detecting a “selection effect”,

where PE investments are simply directed to the fastest growing and least volatile industries. These robustness checks suggested that reverse causality was not the sole driver of results and that PE financing can have industry-level impacts.

It’s a finding that doesn’t surprise the buyout practitioners, however. Jeremy Hand, managing partner at Lyceum Capital, says that throughout his career in the buyout industry he has regularly observed cases where private equity investment in a particular sector has sharpened the performance of other companies in the same sector. “If you look at all the mid-market brands on the high street you can see the impact of private equity,” he says. “Private equity has turned areas like procurement efficiency and store roll-outs from an art into a science. Managers are very good at finding ways to improve margins and cash flow. That forces other companies to react.”

Cross-fertilisationIn addition, PE investment may act as a signal to other businesses in the same sector of changes to come. PE’s ability to transfer knowledge from one industry to another can make competitors wake up. “One of the things private equity does well, investing as it does across numerous sectors, is to cross-fertilise knowledge and experience,” explains Charlie Johnstone, partner at ECI Partners. “We’ve made a number of investments in the online travel sector, for example, and we saw the opportunity to apply what had worked there to the insurance space, where digitisation is not as advanced. Applying experience across sectors in this way is noticed by other businesses in the sector and can lead to wider productivity and efficiency improvements.”

PE’s effect on behaviourYet PE appears to affect more than industry performance. As the Harford et al paper demonstrates, investment seems to change board-level behaviour and decisions. This paper studies the relationship between an LBO and changes to the LBO target’s industry, and finds that PE activity provokes reaction from competitors in a variety of ways. One of the headline findings is that LBOs tend to lead M&A activity in a sector, prompting further deal-making by other financial sponsors and strategic buyers.

Again, this is something well recognised by the buyout firms. “If you take the UK’s veterinary sector as an example,” says Johnstone, “private equity was the first to start making acquisitions with consolidation in mind, but then a significant amount of deal activity followed.”

Private equity clearly affects the companies it backs. But how far does its influence spread beyond individual businesses? Two recent papers suggest the industry’s impact could be greater than might be expected. By Nicholas Neveling


FEATURE

THE FINDINGSPrivate Equity and Industry Performance, by Shai Bernstein (Stanford University), Josh Lerner (Harvard University), Morten Sørensen (Columbia University) and Per Strömberg (Stockholm School of Economics), seeks to establish whether private equity investment in an industry affects the aggregate growth and cyclicality of that industry. The authors use a sample of about 14,300 PE investments between 1991 and 2007, and they aggregate investments by country, industry and year to control for external effects of cyclicality and industry/country macro events. The eventual dataset had approximately 3,900 country-industry-year observations that received PE investment and 4,700 observations that did not receive PE investment. The authors examine the relationship between the presence of PE investment and the growth rates of productivity, employment and capital formation. The analysis measures the growth rate in a particular industry relative to the average growth rate across countries in the same year. In addition, it uses country and industry fixed effects to measure PE activity relative to the average performance in a given country, industry and year.

The study finds that PE investment is associated with faster growth in production, value added, labour costs and number of employees. Importantly, the authors find no evidence that this growth comes at the expense of greater cyclicality and volatility for an industry. In fact, smaller employment fluctuations are associated with PE activity, contrary to a central concern that PE’s focus on financial returns leads to overall reductions and volatility in the labour force. The authors find similar results for the subset of PE investments in the UK and

US, which have higher levels of PE activity, and also for continental Europe. However, the authors do suggest extending the study to capture the impact of the most recent economic cycles.

In How Does an LBO Impact the Target’s Industry?, Jarrad Harford (University of Washington), Jared Stanfield (UNSW Australia) and Feng Zhang (University of Utah) examine the broader impact of PE investments within an industry on industry peers. The authors use a sample of 586 LBOs between 1991 and 2002 to test three hypotheses: first, whether LBO investors deploy capital in industries where change is already under way; second, whether the involvement of an LBO firm sends a signal to other companies in that industry, to which they react by making changes themselves; and finally, whether LBOs affect the competitive nature of the target’s industry, causing industry peers to undergo operational or strategic changes. These three hypotheses are not mutually exclusive.

The authors of the paper conclude that LBOs do prompt a reaction from industry peers, leading to increases in M&A activity, R&D spending, the formation of alliances and share repurchases. Firms are also more likely to change governance structures after the LBO of an industry peer, by introducing anti-takeover provisions, for example. These findings are somewhat consistent with the second hypothesis that PE involvement conveys informational signals, which lead to future industry changes. However, Harford et al believe their results provide the most support for the third hypothesis: PE induces real industry changes through competitive effects.

In addition to increasing M&A activity within a sector, the study also finds that companies respond to PE investment in an industry peer by investing in R&D and forming strategic alliances. Harford adds that there is strong evidence that companies seek to protect themselves from acquisition by restricting board independence, buying back shares, and introducing anti-takeover provisions.

For Rebecca Gibson, a partner at Oakley Capital Partners, this finding in particular rings true. “If you go back to the early 2000s, when the number of buyout-backed take-privates was on the up, you saw a number of companies pay much closer attention to management compensation and retention. Private equity was coming in with the promise of some very attractive deals for management teams, and compensation became a key defensive focus point for corporates,” she says.

PE’s modus operandiJarrad Harford of the University of Washington, however, believes that one of the most interesting points to emerge from the study is what it reveals about the way in which PE is targeting companies and creating value. “In order to assess what impact private equity was having on an industry, we had to establish that it wasn’t just investing in industries where change would have happened regardless,” he says. “That produced some interesting insights into how private equity operates. The analysis showed that firms are not just looking for arbitrage opportunities, but are proactively seeking to move into industries where they can lead change.”

This starts at the individual company level. “In all our interactions with private equity firms, it is noticeable how important driving operational change and elevating the skills of management has become for value creation,” says Andros Payne, managing partner at Humatica, an organisational improvement

consultancy. “Origination increasingly involves identifying targets where the manager sees the opportunity to make operational change.”

ECI’s Johnstone adds that the value of investing in industries undergoing change should not be underestimated. “We do actively seek to improve the companies we invest in, but when you are a lower mid-market investor like us, you are looking for growth stories so you will back companies in industries that are already changing. You look at both aspects,” he says.

It’s clear that PE funds have different strategies to target and grow portfolio companies, and that these affect both the operations and performance of the companies and the returns the GPs deliver to investors. The recent papers by Harford et al and Bernstein et al show that the impact of PE also extends to competitor businesses in sectors where PE has invested.

Putting it all togetherHarford et al find that PE impacts the behaviour of companies in an industry whose competitors have received PE funding. These behaviours include M&A activity and corporate governance. Harford and his colleagues also examine performance using the return on assets metric (ROA) but find no difference between firms with and without PE-financed industry peers. The Bernstein et al paper measures performance in terms of growth in industry production and employment – and finds stronger growth and lower volatility in PE-backed industries.

Bernstein also notes that his research looked at aggregate performance across an industry with PE financing, whereas the Harford paper was more focused on how individual companies react to PE investments in their industry. “The papers tie together quite neatly,” says Bernstein. “We both find that selection bias is not the primary reason behind the observed industry impacts of private equity. Our paper then finds an uptick across overall industry performance, while the Harford paper finds evidence of shifts in company behaviour.”

Next stepsWhile the findings from both papers reflect positively on PE’s impact on industries, adding to the overall debate on the benefits or drawbacks of PE, there is still plenty of scope for further research to build a fuller picture of its influence. For Bernstein, a more detailed analysis of rates of layoffs, plant closings and openings, and product and process innovations, are important avenues for future enquiry. He adds that the buyout boom of the mid-2000s was so massive, and the subsequent crash so precipitous, that it is still too early to fully understand the consequences of PE investment through recent cycles. We’ll just have to wait a few more years before that particular debate can be tackled.

“FIRMS ARE NOT JUST LOOKING FOR ARBITRAGE OPPORTUNITIES, BUT ARE PROACTIVELY SEEKING TO MOVE INTO INDUSTRIES WHERE THEY CAN LEAD CHANGE.”


BE CAREFULWHAT YOU WISH FOR

ANALYSIS

The last few years, and in particular those since the financial crisis, have seen limited partners in private equity and venture capital funds agitate

for better fee and carried interest structures from their fund managers. The creation of the Institutional Limited Partners Association (ILPA) over a decade ago is just one expression of the desire for improved terms and increased transparency among investors.

One item that has almost become received wisdom among many LPs is that European-style carried interest structures – where a manager must return all the fund’s invested capital (plus a pre-determined hurdle rate, where one exists) before earning the performance fee – is more LP-friendly than deal-by-deal carried interest, which is more prevalent in the US. In its list of preferred terms, for example, ILPA says that the whole-fund model described above “should be recognised as best practice”.

However, new research on venture capital funds by Niklas Hüther, David T Robinson, Sönke Sievers and Thomas Hartmann-Wendels suggests that the approach to carried interest structures should be more nuanced. Their paper, Paying for Performance in Private Equity: Evidence from Management Contracts, compares the performance of funds operating on so-called “GP-friendly” contracts that distribute carried interest on a deal-by-deal basis with those that have whole-fund carry terms.

Their conclusions may surprise many pushing for European-style contracts: the research finds that GPs with deal-by-deal carry perform better than those with whole-fund carry, with public market equivalent (PME) returns of 1.241 versus 0.833 gross of fees and 0.967 against 0.638 net of fees, respectively. While the authors suggest that some of the outperformance stems from the ability of better performing GPs to negotiate more GP-friendly contracts, they also find evidence that the terms change investment behaviour.

Counter-intuitive?This seems counter-intuitive, yet one of the study’s authors, Robinson, believes that it reflects how incentives shape behaviour among GPs. “People have a tendency to think of funds with a whole-fund carry structure as being LP-friendly,” he explains. “Yet what I think some have been missing is that contracts affect the choices that GPs make. If I hold constant the GPs investment strategy, then sure, paying the LP first is definitely better for the LP. But what if changing from deal-by-deal to whole-fund changes the way GPs behave? This seems to be what we’re finding: that investment and exit strategies were different based on the contract differences.”

The paper finds evidence that deal-by-deal carried interest seems to provide sharper incentives for GPs to exit at optimal times – the timing of exits in these GPs’ funds is more correlated with the portfolio company’s performance. Meanwhile, for the whole-fund

carry GPs, exits tend to cluster around the end of the fund’s investment period – i.e., when the GPs are about to start raising a new fund. “It’s as if the firms with whole-fund contracts needed to demonstrate a track record and therefore sacrificed some of the potential upside on certain investments to put points on the board,” says Robinson.

“The second effect is that deal-by-deal contracts seem to be associated with taking bigger risks – swinging for the fences, as opposed to going for singles and doubles. With whole-fund contracts, you seem to see funds playing it safe early on, but then ramping up the risk as the fund matures,” he adds.

It’s worth noting that this study was based on data from a single LP and therefore may not hold generally. It was also based on venture capital fund terms and performance, as opposed to those of buyout funds – which is why the study’s findings on investment style are so pertinent.

This distinction between venture capital and buyout funds is important, given the difference in risk profiles between the two types of investment. In fact, Robinson is currently working on a companion paper that looks at the same issue in buyout funds and his findings are – so far – different. “What we’re finding in our VC paper is that deal-by-deal contracts are optimal when you want to provide maximal incentives for swinging for the fences, as is commonly the case in VC,” says Robinson. “On the other hand, many LBO shops deliver great returns by hitting lots of singles, doubles and perhaps triples, but fewer home runs – and our companion paper so far seems to suggest that for LBOs, a whole-fund carry is actually better for the LP than a deal-by-deal strategy.”

Investors in private equity and venture capital funds are increasingly pushing for better fee and carried interest terms. Yet new research suggests that some arrangements widely considered to be LP-friendly could be quite the reverse. By Vicky Meek


ANALYSIS

Finer distinctionsThe findings suggest that LPs need to be making finer distinctions between buyout and venture capital fund terms if they are to generate the best returns possible. “In my experience, there can be an assumption that the economics in VC will be structured in a similar way to buyout funds,” says Nick Benson, partner at Latham & Watkins. “And while established venture capitalists with predecessor funds based on deal-by-deal carry are unlikely to need to switch, for newer groups, where the LP is in a stronger bargaining position, whole-fund carry is more common practice.”

Matthias Ummenhofer, founder of VC firm mojo.capital and former head of the European Investment Fund’s (EIF) technology investment business, agrees. The mojo team is raising its maiden fund on a whole-fund carry basis, but offering co-investments with deal-by-deal carried interest. “Our investor base is largely European,” he explains. “Investors here expect to see whole-fund carry and so, especially as a first-time fund, any deviation would make it very difficult indeed to raise capital.”

Phalippou challenges the way many LPs have historically approached the issue of portfolio company fees. He concedes that some of the fees charged will have been subject to offsets. At the same time, he notes, many of these offsets are subject to a wide range of exceptions, meaning that even with a 100% offset, not all will have been returned to LPs. His research claims that the fees “mechanically reduced performance” since they extract value from the portfolio company. Even where offsets occur, at 3.6% of EBITDA of the portfolio companies in the sample, “the amounts are economically relevant and significantly impact the finances of a large number of corporations”. By negotiating fee offsets rather than questioning the fees themselves, LPs may be reducing the potential for returns.

Fee offsets themselves change GP incentives, and may reduce the impetus to further increase the fees, as Latham & Watkins’ Benson points out. “The norm now is for 100% fee offsets,” he says. “A decade ago, it was commonly an 80% offset, with 20% going to the GP. What people didn’t take into account was that these fees were being extracted from portfolio companies, thus reducing the net profits on which carry was calculated at fund level. The move towards 100% offsets means GPs no longer have such an incentive to charge fees at portfolio level.”

from proportional to the amount of work put into the company. It finds that fees were GP-specific, and did not reflect different business or economic cycles, or the work needed by individual portfolio companies.

“We found that there were some GPs that didn’t charge fees, others that charged moderate fees, and others that charged a lot,” explains Phalippou, co-author of the research. “Yet the amount they charged bore no relation to what they actually did with the company – they were fixed fees that were levied regardless and the contracts were written in a very blatant way – the language was pretty blunt to that effect.”

The authors also quantified the amount charged to portfolio companies, suggesting that GPs had extracted $20bn, or 6% of the equity contributed on behalf of investors, from companies they backed in the sample timeframe (1995 to 2014). This doesn’t necessarily mean that the GPs in the sample pocketed this sum. Many industry experts believe that GPs pass on most of the fees to their LPs via fee offsets. “Most funds now offer 80% to 100% fee offsets,” says Antoine Dréan, founder of placement agent Triago, “so the value passes through to LPs on portfolio company fees.”

Nevertheless, the exit and investment patterns found by Robinson and his fellow academics chime with Ummenhofer’s experience during his 14-year span at the EIF. “Fundraising cycles are much more pronounced in VC than they are in buyouts, especially in Europe,” he says. “There is pressure on teams, especially in younger firms, to exit investments in order to increase fundraising potential. That isn’t always optimal, especially if it can take six to seven years for a company to develop to C-round stage.”

Ummenhofer even suggests that this difference in contract style may account for at least some of the difference in investment strategy between VC funds headquartered in the US and those in Europe. “From what I’ve seen, US VC funds, which usually have deal-by-deal carry, are often more willing to take risks early on in the fund life,” he explains. “In Europe, where whole-fund carry is more prevalent, there can be a tendency to play it safe in the early years, taking less risk on entry to ensure the fund can return capital plus the hurdle rate. At the same time, the suboptimal timing of exits by GPs with whole-fund carry certainly has the potential to limit a fund’s overall return.”

Timing the marketThe effect on performance, Robinson’s research finds, can be significant. “In our study, GPs in VC funds with deal-by-deal structures are much better at timing exits for the peaks in the market,” says Robinson. “While they do better than whole-fund contracts in pretty much every market scenario, they do a lot better than whole- fund GPs in extremely strong markets.”

StepStone partner and investment committee chair Tom Keck agrees that exit timing is a big factor in performance. “Sometimes GPs sell too early because of the risk of carried interest evaporating,” he says. His firm, however, has a preference for whole-fund carried interest not only to avoid clawbacks, but also to control the gross to net spread, as paying carried interest later in a fund’s life reduces its impact on the net IRR.

The impact of fund economics on returns is also explored by research that considers portfolio company fees levied by buyout funds – a subject of focus for the US Securities and Exchange Commission (SEC) in recent years. Private Equity Portfolio Company Fees, by Ludovic Phalippou, Christian Rach and Marc Umber, finds that amounts charged to portfolio companies by GPs in the form of monitoring and transaction fees were far

“PEOPLE HAVE A TENDENCY TO THINK OF FUNDS WITH A WHOLE-FUND CARRY STRUCTURE AS BEING LP-FRIENDLY. YET WHAT I THINK SOME HAVE BEEN MISSING IS THAT CONTRACTS AFFECT THE CHOICES THAT GPs MAKE.”


Dréan agrees that LPs look closely at fees nowadays. “If you go back 20 years or so, LPs didn’t look very closely at the fees being charged,” he says. “But thanks to ILPA and the SEC investigations, among other initiatives, LPs are now very strict on fees that aren’t management fees – they either don’t want fees or they want offsets, and they want clear reporting so that there is full transparency.”

This increased focus on portfolio company fees in recent times is precisely what the Phalippou paper finds. By examining the fundraising performance of GPs against the level of fees charged, the academics find that, post-crisis (2009-15), GPs charging least raised more money in a shorter amount of time.

So were LPs unaware of these fees beforehand? Phalippou thinks not. “LPs knew about them because they were in the documentation – they just didn’t react,” he says. “Around 2011, these fees began hitting the headlines, as the SEC started to investigate them. Once the news was out, trustees and CIOs started asking questions, so the PE teams at LPs had to start acting. I think that’s why we see the results we do in our study.”

Inherent conflict?The Phalippou research raises issues around conflict of interest. “There tends to be a lot of negotiation between GPs and LPs around whether portfolio company fees are partially or fully offset against management fees,” he says. “I’ve often wondered why negotiations centred on the fraction of offset rather than the amount being charged. Until the SEC got involved, no one really talked about how these fees presented a conflict of interest – GPs take money out of the company through these fees, yet the GPs have control of the company boards.”

It’s a point picked up by Keck. “We absolutely prefer GPs that don’t charge management fees to portfolio companies,” he says. “There is potential for conflict of interest because the portfolio company doesn’t have the ability to negotiate at arm’s length with the GP on these fees. Company management also doesn’t like these fees because the team sees them as a dividend the GP is taking out of the company, which they, as equity holders, cannot share in.”

What’s it all for?All of which begs the question of what these fees were (and are) charged for. “While we don’t like these fees, it is possible to argue, especially recently, that GPs provide services and advice to portfolio companies that they would have to pay for anyway,” says Keck. “GPs certainly spend a lot more time making operational improvements to companies, and there is clearly value in that.”

Nevertheless, there are still many well-known firms that don’t charge such fees – Warburg Pincus is one firm that does not levy portfolio company charges. EQT is another. While the latter declined to be interviewed on the subject, it did release this statement to Private Equity Findings: “To promote transparency and to avoid conflicts of interest in relation to investors or portfolio companies EQT does not charge its funds or their portfolio companies any transaction fees, monitoring fees, or any other similar fees relating to a decision to participate in a transaction.”

Benson suggests that fee-free arrangements will remain the exception rather than the norm, and LPs accept that these fees are still customary in buyouts. The main focus, he adds, is on ensuring that GPs are transparent with their investors, so the latter understand the nature of the fees being charged.

With transparency comes a greater ability for an investor to determine whether its interests are aligned with those of other LPs, GPs and portfolio company management. “Alignment is the most important feature of the industry,” says Keck. “It outweighs the macro picture when it comes to performance, and we spend a lot of time on this.”

Overall, these two papers, tackling different aspects of this alignment, provide some interesting insights into how terms are structured and how that structure can affect performance. “Our papers are yin and yang in certain respects,” says Robinson. “However, if you take them together, you get a much richer picture of the industry than if you take either in isolation.”

ANALYSIS

THE RESEARCH In Paying for Performance in Private Equity: Evidence from Management Contracts, David T Robinson, of Duke University, Niklas Hüther, of Indiana University, and Sönke Sievers and Thomas Hartmann-Wendels, both of University of Cologne, explore the timing of carried interest payments to GPs to determine differences in performance between VC funds with deal-by-deal carry and those with whole-fund carry.

Using 85 US VC funds raised between 1992 and 2005, the study measures the timing and size of gross cash flows exchanged between the funds and their 3,552 portfolio companies to produce public market equivalent (PME) returns data. The study finds that, where whole-fund carry is provided for, gross of fee PMEs are 0.833, versus 1.241 for deal-by-deal terms; while net-of-fee PMEs are 0.638, versus 0.967, respectively.

The authors find that exit timing in funds with whole-fund carry terms spikes around the end of each fund’s investment period, often when a new fund is being raised. In those with deal-by-deal arrangements, exit timings more closely match the evolution of net asset values in the underlying companies. In addition, the authors find that GPs with whole-fund carry tend to take less risk up-front, with greater risk-taking as the fund ages, while GPs with deal-by-deal carry have a more uniform concentration

of risk-taking. The paper concludes that different carried interest structures affect returns and GPs’ behaviour in exit timing and risk-taking.

Private Equity Portfolio Company Fees, by Ludovic Phalippou, of Saïd Business School, and Christian Rauch and Marc Umber, of High-Tech Gründerfonds, looks at a different set of fees – those charged by LBO funds to portfolio companies.

Based on 1,044 GP investments, between 1995 and 2014, in 592 leveraged buyouts (drawn SEC filings), the research finds that total fees charged (including transaction and monitoring fees) reached $20bn, on a total enterprise value of the sample of $1.1trn, or 3.6% of the companies’ EBITDA.

It finds that fee levels do not vary by GP performance, by business or LBO cycles, or by company characteristics – but rather that they remain consistent by GP – i.e., the level of fees charged is GP-specific. The study also looks at how fees charged to portfolio companies affect a GP’s ability to raise a successor fund, and finds that in the post-crisis period, past fee structures have had a significant impact: firms charging portfolio companies the least raised more capital in the 2009-14 period. The paper raises questions about conflict of interest, given that these fees are charged to companies whose boards are controlled by the GP.

“I’VE OFTEN WONDERED WHY NEGOTIATIONS CENTRED ON THE FRACTION OF OFFSET RATHER THAN THE AMOUNT BEING CHARGED. UNTIL THE SEC GOT INVOLVED, NO ONE REALLY TALKED ABOUT HOW THESE FEES PRESENTED A CONFLICT OF INTEREST.”


HOW DO SOME LPs OUTPERFORMTHEIR PEERS?

ROUNDTABLE

There are many studies looking into how GPs perform and why, but what about LPs? Why does their performance in private equity vary so much? We speak to the authors of three academic studies in this area, plus two LPs, to gather their views. Chaired by Britt Erica Tunick.

Much has been said about the divergence of returns between private equity fund managers themselves, yet it’s also true that there is a wide variation in the performance of individual limited partner portfolios. Now that the industry has matured significantly, academics have sufficient data to analyse the reasons for the different returns LPs generate from private equity. We consider three papers: the first (by Lerner, Wonsungwai and Schoar) looks into how performance varies according to investor type; the second (by Sensoy, Weisbach, Cavagnaro and Wang) analyses the importance of skill in generating LP outperformance; and the third (by Andonov, Hochberg and Rauh) examines how the governance structures of US pension plans affect returns in their private equity portfolios.

Let’s start with the academics’ perspectives. All three papers examined the variations in performance of LPs’ portfolios. What were the biggest factors you found to account for these differences?

Antoinette Schoar: “We found that foundations and endowments had the best performance in venture capital (although not as strong on the PE side), while banks and funds of funds were worst. The good performance of foundations and endowments is correlated with their ability to predict when partnership performance is likely to deteriorate. Also, they do not invest if a partnership grows very quickly from one fund to the next. Anecdotally, we also heard that LPs who do not treat PE as an asset class do better – meaning they only invest in it if they can place money with good GPs and otherwise sit out.”

Berk Sensoy: “We took the starting point that different LPs perform differently and we tried to dig into that, to figure out the extent to which these differences are due to skill or luck. What

we find is that differences in performance are related to skill levels.

“I should also mention, however, that I have better answers about what doesn’t explain these differences. We do see variations in skills between endowments and public pensions, but we also see a good deal of commonality, and we consequently find less difference between different LP types than Antoinette’s study did. It looks like it’s kind of a maturing industry and some investors are better than others, but it’s hard to put that into neat buckets in terms of what is going to be good. It’s kind of like, ‘What makes a good basketball player?’”

Joshua Rauh: “Our focus was specifically on US public sector pension funds and their governance, particularly the extent to which a board is comprised of politicians. We find there is some underperformance by boards that are heavily populated by participants or members of pension plans, particularly when they are lacking in relevant experience. So we also find that skills are a factor.”

Yael Hochberg: “We also looked at how the incentives of politicians sitting on these boards might differ from those of pension plan participants. We found evidence that politicians are possibly motivated by a desire to achieve other goals, such as economic development and that sort of thing, or by political donations and contributions favourable to their political careers.”


ROUNDTABLE

Going back to LPs’ local investments, the findings in two of the papers are not positive, are they?Antoinette: “No. We find that a high prevalence of local investments has a negative effect on performance. In particular, our research shows that state pension plans (and the pension plans of state universities) are more heavily invested in local (within- the-state) VC and PE funds, and these investments do particularly poorly.”

Joshua: “Our study shows that the underperformance of boards with a strong representation of politicians who are government officials is related to this local investment finding, particularly in real estate. Local real estate investments motivated by political motives tend to underperform.”

What are the views of the professional investors among us? Do you see a direct correlation between the way an LP is structured and the PE returns it is able to produce?Maria Kozloski: “An LP’s structure is hugely important for performance, as it will generally tie into how rigorous your investment process is and whether your governance is aligned with your objectives. Things to consider include: how does your process work? Is it efficient? Does your structure provide the necessary resources for the team to understand the opportunity set? How well are portfolio construction needs being considered in investment decisions, and are those needs reflected in the size of the team? If there is a board in place, what are its objectives? Sometimes a myriad of factors come into play, and you need to be cognisant of them.”

Brad Thawley: “We at Texas Teachers also believe process structure is critically important. And I think that can come down to incentives. Incentivising the PE team to strive for performance and basing incentive structures on performance are critical. I agree with Maria, here, that putting structures in place to ensure team stability is also a critical element in maintaining the LP skills referred to by Berk, as an LP with a higher turnover rate will be disadvantaged compared with its peers. And turnover on a board can lead to unnecessary or unwarranted shifting of commitments or strategies within a portfolio. This affects access to the best managers, too. High-performing GPs prefer LP stability, because that means they don’t have to pitch as frequently or to new LPs who are not acquainted with the fund and thus require more time for due diligence and term negotiations.”

Brad ThawleyBrad Thawley is a senior investment manager for the Teacher Retirement System of Texas, where he focuses on all PE growth strategies across multiple geographies as well as middle market buyouts. Among his responsibilities, he sources new PE GP relationships, monitors those relationships, and performs due diligence for the underwriting of PE investments by the fund. He is a member of more than 20 advisory boards for buyout, growth and venture GPs.

Joshua RauhJoshua Rauh is the Ormond Family professor of finance at the Stanford Graduate School of Business, a senior fellow at the Hoover Institution, a research associate at the National Bureau of Economic Research, and an associate editor of The Journal of Finance. He specialises in empirical studies of corporate investment and financial structure.

Yael HochbergYael Hochberg is an associate professor of entrepreneurship at Rice University, where she serves as the head of the university’s Entrepreneurship Initiative; the academic director for the Rice Alliance for Technology and Entrepreneurship; a research affiliate at the MIT Sloan School of Management; and a research associate for the National Bureau of Economic Research. She is an associate editor of the Journal of Banking and Finance and the Journal of Empirical Finance.

Antoinette SchoarAntoinette Schoar is a professor of entrepreneurial finance at the MIT Sloan School of Management and chair of the MIT Sloan finance department. She is also an associate editor of The Journal of Finance, co-chair of the NBER Entrepreneurship Working Group and the co-founder of ideas42, a non-profit organisation that solves social problems using insights from behavioural economics and psychology.

Berk SensoyBerk Sensoy is a professor of finance at the Ohio State University Fisher College of Business. His research areas of interest include entrepreneurial finance, VC and PE, and empirical corporate finance. He previously worked as a visiting professor of finance at the Fuqua School of Business at Duke University and as an assistant professor at the Marshall School of Business at the University of Southern California.

Maria KozloskiMaria Kozloski is the global head and CIO of PE funds for the International Finance Corporation (IFC). Prior to joining IFC, she was a managing director for Lockheed Martin Investment Management Company, where she headed up PE and real estate, and before that she was with The World Bank Group, where she managed PE for The World Bank’s pension system and invested in emerging markets for IFC.

Joshua and Yael, are you saying that political involvement directly affects pension plan performance?Joshua: “To the extent that governance is linked to political considerations, we find that for every 10% of the board made up of state officials, PE performance is reduced by 0.5% to 0.9% net IRR points. There are three potential explanations: one is the control hypothesis, where politicians are trying to direct funds to local investments that will promote their political careers; the second is straight-out corruption, where politicians direct capital according to ‘pay to play’ considerations; and the third is confusion: that politicians may just be better at politics than they are at investing.”

Yael: “Our research shows that two of these three seem to play out. We find evidence of political favouritism for local investments (e.g., in real estate) and where that happens the investments underperform; we also find some evidence of quid pro quo, where returns are suboptimal as a result of political contributions from the finance industry – the more we see financial contributions to the campaigns of politicians on the board, the worse performance we see. What we don’t see is any problem finding political board members with asset management experience – many are pretty knowledgeable about finance.”

What do others make of this finding?Berk: “Endowments and public pension plans have different governance structures, and in the past people have found differences in performance across these LP types. But I’m not sure that plays out so much anymore: as the industry has matured, more expertise has become available and LPs have adopted best practices. I think, however, there is a recognition that political pressures should be avoided when it comes to investment decisions.”


ROUNDTABLE

The LPs clearly believe financial incentives are vital to performance. What does the research say on this?Berk: “Incentivisation is very important: if you don’t have strong incentives, it’s not likely that you’ll see significant differences in outcome attributable to skill, as opposed to noise. Unfortunately, we’re not able to measure the strength of incentives within individual LPs, and the skill sets within those LPs, because we just don’t have the data.”

Antoinette: “Yes, there is little or no data that allows us to measure the incentives that the investment managers in different types of LP receive. However, we have heard anecdotes to suggest that endowments take a more long-term approach. They do not incentivise managers simply to ‘put money into the asset class’, which might lead managers to focus on the volume of capital invested in PE, rather than their chosen funds’ quality or expected performance.”

So is it possible for LPs to attract experienced PE investors without sacrificing efforts to maintain manageable compensation schemes or violating governance requirements?Maria: “I think so, but you do need to pick your decision-makers well; you need a certain level of skill and experience within an investment team. LPs should provide incentives to those who manage investments well and should build teams that will stay. Institutions do well if they hire talented individuals for their in-house team who believe in the mission of the institution they are representing, and who are also vested in the outcome.”

into the best GPs. The big trick in PE investing is to determine which GPs are good and to persuade them to take your money, as the best ones won’t usually accept money from just anyone. Our paper shows that some LPs are better at that than others; the consistency of their outperformance cannot be attributed to just noise or luck. So what we’re finding in PE is that you need to pick your PE limited partner personnel well.”

Brad: “One of the things that jumped out as being particularly interesting is the ‘seat at the table’ suggestion – the notion that endowments benefit from historical access to top-tier GPs, which they gained in yesteryear. They have a seat at the GP table, whereas new entrants don’t have the benefit of access to the same managers. When I think about Texas Teachers and our strategy versus other new entrants within the past decade, we focus our strategy for capital deployment on what we can control – things such as large size, ability and willingness to make a large commitment, long-term partnerships, and our unique view of the competitive landscape. We play to our strengths… The other big takeaway for me is that it gives historical context about how much the PE industry has evolved and continues to evolve. The industry’s strategies and sub-strategies have changed in both complexity and breadth since the early 1990s, and understanding this is essential for future planning.”

Maria: “These papers are a good reminder to institutional investors of how important it is to set up your structure well: how the investment process will function, and how decision-making will be done. This will have a notable impact on performance. You shouldn’t short-change that, because it will make a big difference to the organisation itself.”

Brad: “Yes, one thing LPs can do is to hire individuals who are particularly interested in the greater cause – whether that means they are driven to improve retirement for teachers, or that they have a passion for an endowment’s mission. Another approach is to bind the incentives of the investment professionals with the cause of the beneficiaries, to make sure they are striving for a clear goal closely aligned with the endowment’s own goal.”

Assuming you have the right incentives and governance in place, is LP performance then down to skill?Brad: “Only to a point. An LP’s access to top performers may not necessarily be based on skill but rather on the size of the LP. Many pensions or sovereigns are just too large to justify investments into smaller GPs, and the funds they do access may have different risk/reward ratios.

“Another issue is the risk appetite of the LPs, as this is a super-large contributor to returns in various market conditions. The research does acknowledge that there are unobservable conditions at play here and that these could have an impact on the findings. Additional factors that could be included in the risk, but are difficult for the academics to measure, could be the underlying investments themselves, the spread of returns, the use of leverage in companies, team chemistry risk, culture risk, valuation environment – all of which are extraordinarily difficult to adjust for in the findings. I think the reality is far more nuanced than some of the findings suggest.”

And do some LP types really outperform others, in your experience?Brad: “I’m not convinced by the lumping together of LP types. Some of the research refers to buckets of LPs, and at times there is overemphasis on the similarities of LPs within those buckets. There is actually a lot of deviation in the strategies of LPs within each bucket.”

Maria: “I agree. I don’t think it’s the LP type that matters per se. The research suggests that endowments do better, followed by corporate pension plans and then public pension plans. But endowments, followed by corporate pension plans, have been in the investment class longer. When they got started, it was a more nascent market. The market today is just far more competitive for PE, so investors who are latecomers to the market won’t have some of the advantages of LPs that were 15 or 20 years ahead of them into the asset class.”

So what should LPs take away from the research?Yael: “For most of the public pension funds we examined, their board composition was set by statutes many years ago and is fairly stagnant. That opens up a lot of questions regarding the sort of predilections we might be seeing from a certain type of board member and how that affects the ability of a public pension fund to maximise its returns.”

Berk: “I think it’s a talent evaluation approach. There’s a large body of information suggesting that in the huge universe of mutual funds there is not much difference between constituent members, and you might as well just pick an index. However, the PE literature generally teaches us that there are differences in the skills of GPs, and as an LP you need to get

THE RESEARCH Smart Institutions, Foolish Choices?: The Limited Partner Performance Puzzle by Josh Lerner and Wan Wongsunwai, both of Harvard University, and Antoinette Schoar of MIT Sloan School of Management, examines how LP performance varies according to investor type. Based on data from 352 LPs and 838 private equity funds, it finds that, on average, endowments generated returns that were nearly 21% higher than those of the average LP, while banks performed the worst. The academics find that endowments (and to a lesser extent public pension funds) are better than other investors at predicting whether a follow-on fund will have high returns. Their research also suggests that this type of LP proactively uses the information gained from being an existing investor in a predecessor fund when selecting funds for investment, while other LP classes do not. Overall, the academics find that LPs vary in sophistication levels and objectives.

Measuring Institutional Investors’ Skill from their Investments in Private Equity examines to what extent returns vary between LPs. Berk A Sensoy and Michael S Weisbach (both of Ohio State University) and Daniel Cavagnaro and Yingdi Wang (both of California State University, Fullerton) use a sample of 12,043 investments made by 630 LPs to determine the importance of LP skill in private equity performance. By comparing the theoretical distribution of returns if LPs had made random commitments to the study’s fund universe with the distribution of returns from LPs’ actual fund commitments, they find persistence of performance over time among individual LPs. Higher-skilled and lower-skilled LPs consistently outperform and underperform respectively. They find

that an increase of one standard deviation in skill levels leads to a 3% increase in IRR.

In Political Representation and Governance: Evidence from the Investment Decisions of Public Pension Funds, Aleksander Andonov (Erasmus University), Yael Hochberg (Rice University) and Joshua Rauh (Stanford University) explore the relationship between pension fund governance and private equity investment performance. Using data on US public pension plans and biographical data on board members, plus data on private equity funds and performance drawn from Preqin, the academics find that pension fund boards with a higher proportion of government officials are associated with poorer performance in private equity investments. Boards with high percentages of members elected by pension plan participants/beneficiaries also perform poorly.

For each 10 percentage points of the board made up by government officials, performance is reduced by between 0.9% net IRR and 0.5% net IRR. These boards tend to invest more in real estate and funds of funds, and show a bias towards small, in-state, and less experienced fund managers. According to the research, this factor accounts for between 50% and 60% of the underperformance. When looking at reasons for this underperformance, lack of financial experience (confusion) is a contributing factor for boards with high member-elected representation, but not for those with a high proportion of state officials, many of whom have good financial knowledge. For the latter, the academics find that political contributions (corruption) and political favouritism (control) are negatively related to performance.


ASSESSING THE IMPACT

HEAD TO HEAD

Initiatives such as the Principles for Responsible Investing (UNPRI), established by the UN in 2006, demonstrate the high interest in

socially responsible investing. Nearly 1,500 organisations – representing almost $60trn of assets under management – are signatories, but relatively little capital has been actually deployed with the expressed intent of generating social impact. Observing that private capital, unlike philanthropy and government programmes, has the scale to address global social and environmental challenges, a new paper by academics Brad Barber, Adair Morse and Ayako Yasuda analyses the demand for a specific type of fund designed to meet such demand – the impact fund.

“We wanted to find out which investors were committing to impact funds and what was driving them to do so,” says Yasuda. “After all, traditional models of finance assume that investors target only financial returns.”

What they found surprised the authors. “We had expected there to be some variation in appetite for impact between investors, but we didn’t think we’d find such a great disparity or such a rich variation,” says Yasuda. By comparing the investment rates into impact funds with those of more traditional VC funds, not only did they find above-market demand for impact funds overall, but also that certain types of investor were more interested in impact funds than others. Public pension funds, banks, insurance companies, foundations and – naturally – development organisations all had high demand for impact funds. By contrast, endowments appeared to actively avoid impact, with similar, although weaker results for corporate and government investors.

“We were particularly surprised by the strength of the result for households (i.e., investors, such as pension funds, which are investing on behalf of households),” adds Yasuda. “There, we found that LPs with a household constituency increased demand

by over 13%.” This links to academic research into other areas of sustainable, responsible, impact investing (SRI), she says. “There are related findings in other studies suggesting that non-pecuniary considerations are important to many households. There is evidence that some households value social or environmental outcomes – such as ensuring a less degraded environment for future generations – and are prepared to make investment choices accordingly.” (See page 16 for an article about the oversight of a key institution that invests for households, public pension funds, which suggests the possibility of substantial governance issues in many cases and offers perhaps another explanation of these results.)

The study also found that certain categories of LPs displayed significantly higher above-market demand (i.e., higher investment rates compared with traditional VC funds) for impact funds than others. Perhaps predictably, LP signatories to the UNPRIs had stronger above-market demand for impact funds (25.8%) than did non-signatories (7.1%). Yet geographic location also played a part: European investors were found to have three times the amount of above-market demand for impact funds of US investors.

The reasons for the variations, according to the research, boil down to high demand among those investing on behalf of households (as per above), mission-focused investors and those facing political or regulatory pressure to invest in impact (such as the Community Reinvestment Act legislation for US banks); those less inclined to invest in impact funds are generally those facing legal restrictions against non-financial investment, such as those subject to the Employee Retirement Income Security Act (ERISA) and the Uniform Prudent Management of Institutional Funds Act in the US. Interestingly, however, the authors found that organisational charters requiring a focus on financial returns didn’t hinder demand for impact funds.

Yet impact investing comes at a cost, as further research by the authors is starting to uncover. “We’re currently working on a follow-on study that, so far, suggests that investors in impact funds should expect some trade-off in returns – the initial findings are that returns are lower for impact funds than for traditional venture capital and growth funds. However, we also find that investors are willing to accept this.”

This leads to a separate – but related – question: does this finding provide an incentive for funds to badge themselves as impact funds? Not according to Yasuda. “All funds these days have boilerplate about ESG,” she says. “But impact funds are different in that they explicitly state that their objective is to generate social or environmental externalities – these are non-financial objectives. If you are raising capital in a competitive marketplace, that is a disadvantage as not all investors find this an attractive attribute and some, such as ERISA investors – which account for a large amount of capital – face restrictions in investing for impact objectives above financial ones.”

Impact investing has risen in popularity, but which investors are looking closest at this type of fund? We look at a new paper on the subject and asks one experienced LP for her opinion.

Ayako YasudaAyako Yasuda is a visiting associate professor of finance at Haas School of Business, University of California Berkeley. She has received numerous professional awards and has published in leading academic journals such as The Journal of Finance, Journal of Financial Economics and the Review of Financial Studies. She co-authored an MBA course textbook Venture Capital and the Finance of Innovation, which has been adopted at many of the world’s top universities.

“ WE HAD EXPECTED THERE TO BE SOME VARIATION IN APPETITE FOR IMPACT BETWEEN INVESTORS, BUT WE DIDN’T THINK WE’D FIND SUCH A GREAT DISPARITY OR SUCH A RICH VARIATION.”


LIFE ON THE INSIDE

Michael EwensMichael Ewens is the associate professor of finance and entrepreneurship at the California Institute of Technology (Caltech), which he joined in 2014. Ewens is also a quantitative advisor for Correlation Ventures, a quantitative-focused venture capital firm based in San Diego.

Start-ups with big ambitions often rely on venture capital to help drive growth, and many of the most successful companies will welcome

on board a growing number of venture capital backers as they get closer to a successful exit. However, this is not always the case. Around 30% of investment rounds (excluding initial investment rounds) in entrepreneurial companies between 1992 and 2014 are classified as “insider” financing rounds, where no new investors were involved.

Academics Michael Ewens, Matthew Rhodes-Kropf and Ilya Strebulaev undertook an exhaustive study, reviewing the performance of over 10,000 VC-backed companies, to analyse the difference in outcome between insider and outsider funding rounds. They found that the former are more likely to leave investors worse off, with inside rounds associated with a higher likelihood of failure, lower probability of IPO and lower cash-on-cash multiples than rounds with new investors. Private Equity Findings caught up with Ewens to discuss the findings.

Why did you decide to explore this area of research? “The setting of inside rounds is an environment where predictions from economic theory are quite clear, but when I first investigated the simple relationships, the patterns went in the opposite direction.

“The paper’s findings are different than you might expect – we’re not seeing evidence of situations where the entrepreneur is being taken advantage of.”

To what extent did you expect to find that inside rounds led to poorer outcomes? “When I first started looking at this area, years ago, I found it surprising, and I only found it more surprising as time went on. Venture capital is extremely expensive for everyone involved, apart from the venture capitalists themselves. LPs pay a fee, while entrepreneurs give up control, and large equity stakes, to preferential shareholders. In that setting, you would think that VC managers would extract an enormous amount of value from entrepreneurs by doing inside rounds at very low prices, in order to increase their returns at exit.”

Is the implication therefore that new investors cast a more critical eye over the numbers?“That is certainly consistent with the story, although maybe a better way to say it is that an outside investor evaluates the company going forward rather than its value now and looking back. It’s almost as if outsiders bring a discipline that means you don’t overpay, which is the opposite of what a standard model would predict.”

How do inside rounds of venture capital, where only existing investors provide fresh capital, perform? And what motivates VC managers to do inside rounds? A new piece of research sheds light on these issues. By Peter Kneller

For long-standing private equity investor Ilmarinen Mutual Pension Insurance Company, the issue is clear. “The law mandates that we invest in a secure

and profitable manner – we have to pursue returns as our objective,” says the investor’s senior private equity portfolio manager Katja Salovaara.

However, the issue is larger than a straightforward legal obligation, she adds. “If you are investing on behalf of pensioners, they are relying on the returns that you generate for their retirement income,” she says. “If you don’t generate adequate returns, the contributions necessarily have to rise. Most investors are structured to benefit the ultimate constituents and so in most cases, it’s hard to argue that impact objectives should be followed if there is a trade-off with returns. If the constituents wish to follow an impact objective, there needs to be an opt-in or opt-out mechanism.”

Salovaara also argues that it is possible to have an impact socially or environmentally without sacrificing returns by investing in private equity more generally rather than specifically in impact funds. “Many buyout funds make investments that arguably have a significant impact socially or environmentally,” explains Salovaara. “They can do so because they operate at a much larger scale than the VC and growth funds examined in the study.” She points to the example of an investment in an irrigation company. “The investment to help this company grow to scale provides the potential for good returns,” she says. “But because of the scale, its effect on saving water and improving crop yields is significant. If you want to make an impact globally, while also focusing on returns, buyout-backed businesses can provide the solutions. If you focus on a subset of VC funds, the impact will be much lower and the returns are affected because VC funds are expensive vehicles – the bar is higher to generating returns.”

And then there’s the question of investor type. “It’s very interesting that endowments are least likely to have demand for impact funds,” says Salovaara. “Studies have shown (see Roundtable, page 12) that endowments are some of the best-performing LPs.”

Finally, given the appetite demonstrated by the research, Salovaara suggests that there is a “meaningful” incentive for firms to market themselves as impact funds. “LPs do need to be sceptical of some of the claims,” she says. “The measurement of social and environmental impact is very difficult to achieve with any degree of accuracy. As ever, there is no substitute for thorough due diligence.”

Katja SalovaaraKatja has been a senior private equity portfolio manager at Ilmarinen since January 2000. Ilmarinen is a mutual pension insurance company based in Helsinki, Finland, managing €36bn, with 6% currently invested in PE. Before joining Ilmarinen, she worked at the Shell UK Pension Fund in London analysing PE funds and monitoring a global private equity portfolio with over $1bn of commitments. Before that, she worked at Pantheon Ventures.

THE LAST WORDHEAD TO HEAD

THE RESEARCH Impact Investing, by Brad M Barber and Ayako Yasuda of University of California, Davis and Adair Morse of the Haas School of Business, University of California, Berkeley, examines the demand for impact venture capital and growth funds among limited partners. Using a dataset comprising over 25,000 capital commitments to more than 5,000 funds and a hand-collected sample of 161 impact funds, it finds that there is a 14.1% higher investment rate in impact funds (defined as having dual impact and financial objectives), compared with more traditional VC and growth funds and that this excess demand has increased substantially in recent years, with above-market demand rising from 7.1% in the period before 2007 to 21.8% from 2007 and onwards. The authors also document that above-market demand is present among development organisations (17.7%), foundations (11.1%), banks (22.2%), insurance companies (24.0%) and public pension plans (17.3%), while other investor types eschew such funds, including endowments (-31.1%) and corporate or government investors. They find evidence that above-market demand for impact is driven by households (as opposed to organisations), mission-focused investors and those facing political or regulatory pressure to invest in impact.


THE LAST WORD

So are venture capitalists using insider financings as a “backstop” when portfolio companies are struggling to raise capital?“When we asked venture capitalists why they thought other venture capital managers conduct inside rounds, one of the more popular answers was that they might be trying to help a company recover from a recent shock. Yet as an insider I’m not just considering this individual series C, I’m considering the whole position I have in the start-up. By not investing in this company and letting it fail, I lose, let’s say, a $10m stake, but if I put $500,000 in, I can increase the chances of the company not going under.”

How might the way funds are managed and raised account for poorer outcomes for inside rounds?“An important assumption that people make when they say that this is a bad investment is that there is some kind of benchmark for the right return. When venture capitalists make a new investment in a start-up, they must believe that its returns will at least exceed the opportunity cost of investing in an average start-up.

“Maybe these inside rounds are occurring at a point in the fund’s lifecycle where the cost of capital – the underlying risk-adjusted return to rationalise investments – is lower. The evidence suggests that the propensity for inside-round behaviour tends to be much higher when venture capitalists are in the second half of a fund – a time when most investors are restricted from making new investments.”

Why do you think inside rounds tend to be negative net present value? “What’s important here is that the cost of capital is changing over the fund lifecycle. An NPV analysis that ignores the fund lifecycle and settles on a fixed 15-20% cost of capital looks like sending good money after bad. But taking into account the fund lifecycle, the NPV analysis could turn positive.”

You looked into whether venture capitalists were window dressing their fund performance through inside rounds, didn’t you? What did you find?“The best time to window dress would be when managers are raising a new fund. However, while I think window dressing plays a role in a significant fraction of these deals, there is very little evidence in the data to suggest fundraising is linked to big, overpriced inside rounds happening more often.”

So should the VC fund model be changed?“It’s unrealistic to think we can find a contract to resolve every single thing. My view is that despite the underperformance of inside rounds, the benefits that come from the limited fund life, the investment period rule, and all the other terms that LPs and GPs have negotiated over the years, outweigh the costs of inside-round behaviour.

“One of the more interesting facts that has emerged from the data I work with is that, across venture funds as a whole, there is very little difference in the fraction of a fund’s investments that fails. What really separates the best-performing funds is a couple of big winners.”

What should venture capitalists and LPs take away from the findings of your research?“Looking at it as a potential syndicate member, I think it’s important to consider the fund stage of the existing investors. In a sense this input can be predictive for both LPs and outsiders, in a way that maybe could help bring capital to some of these rounds. Some of these rounds are overvalued, and it’s possible that if outsiders were able to incorporate this additional information – that they’re in the second half of the fund, etc – that could give them an edge in understanding what the right deal and price is.

“LPs don’t like inside rounds. Their view is often that this isn’t a priced round because they didn’t have the market come in and say what the right post-money valuation is. Maybe one lesson from this is, again, to incorporate the fund lifecycle into this and treat inside rounds as a little more complex.”

THE RESEARCH Inside Rounds and Venture Capital Returns by Michael Ewens of Caltech, Matthew Rhodes-Kropf of Harvard University and Ilya Strebulaev of Stanford University analysed the outcome of investment in 10,104 venture capital-backed entrepreneurial firms from 1992 to 2014, assessing the findings from 22,382 investment rounds (excluding the initial investment rounds), of which 6,645 financings were inside rounds (approximately 30%). More than 40% of the firms in the sample are from California, while the information technology sector comprises more than half of the dataset.

The research uncovered that inside rounds are 20% more likely to lead to failure, are 27% less likely to lead to IPOs, have 30% lower exit valuations, and generate 15-18% lower cash-on-cash multiples than outside rounds. Inside rounds also appear to have a negative NPV, suggesting that investors make inefficient follow-on decisions. These suboptimal investment decisions can be attributed in part to the dynamics of the VC fund lifecycle, in which, post-investment period, venture capitalists must allocate remaining capital solely to existing investments. This lowers the opportunity cost of making a follow-on investment.

Contributions from:California Institute of Technology

California State University

Columbia University

Duke University

Erasmus University

Haas School of Business

Harvard University

High-Tech Gründerfonds

Indiana University

MIT Sloan School of Management

Ohio State University

Rice University

Saïd Business School

Stanford University

Stockholm School of Economics

University of California Berkeley

University of Cologne

University of Utah

University of Washington

UNSW Australia “ IT’S ALMOST AS IF OUTSIDERS BRING A DISCIPLINE THAT MEANS YOU DON’T OVERPAY, WHICH IS THE OPPOSITE OF WHAT A STANDARD MODEL WOULD PREDICT”

PRIVATE EQUITYFINDINGS

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© 2009-2017 Coller Capital

Published by the Coller Research Institute with the

support of Bladonmore and Bella Research Group.

26 PRIVATE EQUITY FINDINGS WINTER/SPRING 2017

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